When comparing mutual fund fees, most plan advisors only focus on a fund’s total expense ratio (external costs), while failing to calculate a fund’s trading costs (internal costs) — commissions, bid/ask spreads and market impact costs. This focus on external expenses is understandable given that funds don’t publish internal expenses and not everyone agrees on the right methodology to calculate them.

Despite the fact that internal expenses are not readily available, two important questions need to be answered: How do internal costs compare to external costs and, more importantly, do they have a negative impact on investment return? “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance,” an article by Roger Edelen, Richard Evans and Gregory Kadlec published in the Financial Analysts Journal, provides some answers to these questions. The article takes a close look at both internal costs compared to external costs and the correlation between internal costs and fund return.

The authors also provide a method for approximating a fund’s internal costs. The traditional proxy for internal costs has been a fund’s turnover rate. The shortcoming of focusing only on fund turnover is that it does not capture the impact of fund size (i.e., trade size) and stock liquidity (i.e., small cap versus large cap). For example, a small cap fund may have half the turnover of a large cap fund and still have higher internal costs. The authors offer a methodology they call “position-adjusted turnover” that makes allowances for fund size and stock liquidity. It is a helpful tool to approximate internal fund costs that are otherwise hidden.

The article provides a great deal of detail about the methodology the authors utilized for estimating internal fund costs. They applied this cost analysis to a sample of 1,758 domestic equity funds over the period 1995-2006, and found that:

Sorting funds based on their aggregate trading-cost estimate yielded a clear monotonic pattern of decreasing risk-adjusted performance as fund trading costs increase. The difference in average annual return for funds in the highest and lowest quintiles of aggregate trading cost was –1.78 percentage points.

Clearly, the average fund’s internal costs are significant (on average being larger than the external costs) and these costs have a deleterious impact on fund return. This could be due to the added cost being created by a hyperactive manager who has an ever-shifting investing strategy. Or perhaps this lower return could reflect forced turnover due to hot money moving in and out of a fund, thus driving up transaction costs. In many respects, it really doesn’t matter why there is a correlation. It is important to simply note that a significant negative correlation exists between the level of a fund’s internal expense and its ultimate return.

In addition to calculating these internal expenses, there are other ways advisors can sort out funds that are likely to have high internal costs:

Select mangers who have a history of adhering to a well-defined process and philosophy, and so are more likely to make slight course corrections as opposed to making wholesale changes to their investment mix.

Choose funds that have low demands on liquidity, such as those focused on institutional investors as opposed to “popular” funds held primarily by retail brokerage accounts. (In the DC world, this is one of the main attractions of collective investment trusts.)

When it’s practical to do so, choose custom indices as opposed to commercial indices. Custom index managers have greater latitude to trade in a patient manner without having to worry about “tracking error,” and thus have greater flexibility when it comes to managing trading costs, especially bid/ask spreads.

Conclusion

Based on these findings by Edelen et al., there is little doubt that internal expenses do matter since they tend to be higher than external expenses and, on average, have a negative impact on investment return. It is also possible to deploy a relatively simple formula for estimating these costs. Finally, there are ways to weed out the overactive managers and identify funds that contain too much “hot” money.

Advisors should take a hard look at the impact of internal expenses, especially when utilizing active managers. The plan advisor can be especially helpful to the plan sponsor by making the invisible, visible.

Jerry Bramlett is the Managing Partner of Redstar Advisors, a boutique consulting firm focused on digital advice solutions. This column originally appeared in the Summer issue of NAPA Net the Magazine.

Add Your Comments

Add Your Comments

Hello,
Thank you for your recent article by Jerry Bramlett citing the CFA Institute Financial Analysts Journal article from 2013,”Shedding Light on Invisible Costs: Trading Costs and Mutual Fund Performance,” by Edelman, Evans and Kadlec.
May I request that you include a direct link to the original story, which is below for you, so that readers can view the article more easily?
Here’s the link to the original article:http://www.cfapubs.org/doi/abs/10.2469/faj.v69.n1.6
Thanks in advance for your support and excellent article!
Best,
Michele Armentrout
CFA Institute Content Engagement & Publishing